DBRS Downgrades and Places Debussy DTC Plc Class A Under Review with Negative Implications

DBRS Ratings Limited (DBRS) downgraded its rating on the Commercial Real Estate Loan Backed Fixed-Rate Notes due July 2025 (the Class A Notes) issued by Debussy DTC Plc to BB (low) (sf) from BBB (low) (sf).

Additionally, the Class A Notes were placed Under Review with Negative Implications.

The rating downgrade reflects the imminent decrease in credit characteristics of the transaction as a result of Toys R Us’s (TRU) proposed Company Voluntary Arrangement (CVA), which it announced on 4 December 2017 (CVA Proposal). DBRS analysed the CVA Proposal and determined a set of potential scenarios, the most favourable being reflected in the updated rating. TRU’s creditors are scheduled to vote on the CVA Proposal on 21 December 2017. DBRS placed the transaction Under Review with Negative Implications because of the uncertainty related to the vote and the to-be-determined strategy of the borrower and servicer, if the Proposed CSA is approved. DBRS intends to review the transaction once the outcome of the CVA Proposal and potentially the strategy of the borrower and servicer, are more visible.

Debussy DTC Plc is the securitisation of 30 mega retail stores and one distribution centre operated by TRU. The properties are mainly located in secondary and tertiary markets in the United Kingdom. All properties are registered under Toys “R” Us Properties (UK) Limited and are operated under individual triple-net leases to Toys “R” Us Ltd., with leases expiring in February 2036 or February 2037. TRU is currently paying above-market rent with an annual rental rate increase based on the retail price index (RPI) and subject to a 1.0% floor and a 2.5% cap. The securitised loan is interest-only and the borrower will have to repay GBP 263 million at maturity in July 2020. There is no extension option but the loan maturity date could be potentially extended to July 2023 at the latest, two years before note maturity. More details can be found in DBRS’s 21 July 2017 press release, when DBRS confirmed its ratings on Debussy DTC Plc and assigned a Negative trend to the Class A Notes.

On 21 December 2017, TRU’s creditors and shareholders will vote on the Proposed CVA. If agreed by at least 75% of its debtors, the CVA will enable TRU UK to restructure its finances and reposition its real estate portfolio. If more than half of its debtors vote against the CVA and no agreement is reached, TRU could be forced to file for bankruptcy in the UK, highly likely resulting in store closures. If implemented, the CVA period will begin on the date that it is approved (effective date) and will continue until the supervisors have finished executing its terms, which although uncertain, is expected to be within four years, i.e. by 21 December 2021, a year and a half after the scheduled maturity of the securitised loan in July 2020.

TRU currently has 88 permanent and 21 temporary stores in the UK. The CVA Proposal splits the property portfolio into five categories based on the stores’ profitability and size, and subsequently recommends where rent reductions, downsizing or store closures are required.
Category 1 stores are those that are performing well and do not require any modifications. In TRU’s opinion, both Category 2 and 3 stores require downsizing. For these categories, according to the CVA Proposal, TRU and its store’s landlords would have seven months to agree the terms of a downsize, after which a 15% reduction in rent will be proposed as an alternative. Additionally, the CVA Proposal entails immediate rent reductions for all unprofitable stores. As Category 2 stores are currently profitable, they do not require any immediate reduction in rent. Category 3 stores (which do require downsizing) and Category 4 stores (which do not require downsizing) would both have immediate rent reductions of 35%. As Category 5 stores have been deemed to have no future viability, following an immediate rent reduction of 50%, store closures would begin in spring 2018.
In addition to the immediate rent reductions, the CVA Proposal includes lease termination rights with 45 days notice period for properties in Category 2, Category 3, Category 4 and Category 5 (for Category 2 properties there is no termination right for the first seven months after the effective date). The CVA also proposes to change the rent collection cycle for all property categories from quarterly in advance to monthly.
Out of the 31 securitised assets in the Debussy transaction, seven (13.3% of total Annual Rental Income) fall into Category 1 and are therefore unaffected by the Proposed CVA, except for the changed rent collection cycle; another seven (16.6% of the transaction’s total Annual Rental Income) fall into Category 5 and thus would likely be closed next year. The remaining 17 assets require a mix of downsizing and rent reductions.
Presuming the CVA Proposal is approved, DBRS has assessed the rental impact in five different scenarios. DBRS has analysed each of the possible scenarios using the current rental values given in the October 2017 interest payment date (IPD) report, which totalled GBP 24.8 million.
Scenario 1 - if approved on 21 December 2017, the portfolio would incur an immediate rent reduction of 35% for both Category 3 and Category 4 stores and 50% for Category 5 stores. Overall, this would cause Debussy’s total annual rent to decrease by 26.0% to approximately GBP 18.4 million.
Scenario 2 - if no downsizes are agreed but instead a further 15% rent reduction is applied to Category 2 and 3 stores, total annual rent would decline by 41.8% to approximately GBP 14.5 million.
Scenario 3 - if downsizes for Category 3 and 4 stores are agreed within the seven-month period and no additional rent reductions are required, total annual rent could be approximately GBP 11 million, which is a 55.0% fall. To calculate the estimated rent post-downsizing, DBRS used the current rent per square foot and applied a 50% reduction in the size of the Coventry distribution centre and the most conservative target size stated in the CVA of 20,000 square foot for the retail properties. The estimated rent does not include the potential of re-letting downsized or vacated space.
Scenario 4 - if TRU closes all of the UK stores except for the 24 in Category 1 (seven of which are in Debussy), not including potential re-letting, the transaction’s total annual rent would drop to around GBP 3.3 million, an 86.7% decrease.
Scenario 5 - based on the CVA documentation assumptions and current passing and market rents, the expected total annual rent at the end of the process, would be around GBP 17.2 million, a 30.5% reduction from October 2017’s IPD, assuming no vacated spaces are subsequently let.
The latest reported market value and vacant possession value of the portfolio are GBP 359.4 million and GBP 196.4 million respectively. However, to derive such values, the surveyor has assumed the assets would be let at current rent (market value) or market rent (vacant possession value). Should the CVA Proposal be implemented TRU would pay below the currently reported market rent, resulting in a possible ICR trigger breach and/or interest payment default during 2018, which would cause the loan to be transferred to the special servicer.

In lieu of a third-party liquidity facility, the borrower has established the Borrower Security Reserve Account and funded it with GBP 19,300,000 to provide liquidity support to the Class A and Class C Notes Senior Additional Payments (0.5% per annum on Class C outstanding balance and ranking senior to Class A note interest and principal). In addition the transaction features a Reserve Account which is currently funded to its maximum at GBP 3 million. The Reserve Account can be used to pay interest due on the securitised loan, which could become relevant on the January 2018 IPD as the change from quarterly to monthly collection cycle would likely result in (reduced) rental income not being sufficient to pay interest on the loan. Cash on the Borrower Security Reserve Account could be used to pay interest due on the Class A notes, mitigating the risk of a note payment default should the borrower default on its loan interest payments due. DBRS estimates that the Borrower Security Reserve would be sufficient to enable the issuer to pay 1.5 to 2 years of interest due on the Class A notes.

The economics of the Proposed CVA and the alternative outcome if it was not agreed by TRU’s creditors puts pressure on cash flow and property values, resulting in higher default (immediate and refinancing) risk and ultimately higher loss risk. In its review DBRS will likely reduce its sustainable net cash flow assumption for the property portfolio (currently GBP 21.5 million) by at least 10%, causing the downgrade to BB (low) (sf) and the placement of Under Review with Negative Implications.

Notes:
All figures are in British pound sterling unless otherwise noted.

The principal methodology applicable to the rating is: “European CMBS Rating and Surveillance Methodology.”

DBRS has applied the principal methodology consistently and conducted a review of the transaction in accordance with the surveillance section of the principal methodology.

A review of the transaction legal documents was not conducted as the legal documents have remained unchanged since the most recent rating action.

Other methodologies referenced in this transaction are listed at the end of this press release.

These may be found on www.dbrs.com at: http://www.dbrs.com/about/methodologies

For a more detailed discussion of the sovereign risk impact on Structured Finance ratings, please refer to “Appendix C: The Impact of Sovereign Ratings on Other DBRS Credit Ratings” of the “Rating Sovereign Governments” methodology at: http://dbrs.com/research/319564/rating-sovereign-governments.pdf

The sources of data and information used for this rating include Situs Asset Management Limited and U.S. Bank Global Trust Services.

DBRS did not rely upon third-party due diligence in order to conduct its analysis.

At the time of the initial rating DBRS was not supplied with third-party assessments. However, this did not impact the rating analysis.

DBRS considers the data and information available to it for the purposes of providing this rating to be of satisfactory quality.

DBRS does not audit or independently verify the data or information it receives in connection with the rating process.

The last rating action on this transaction took place on 21 July 2017, when DBRS confirmed the rating at BBB (low) with a Negative trend.

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.

Because of the uncertainty surrounding the transaction’s future cash flows until 21 December 2017, DBRS has not performed sensitivity analysis at this time. Below is the sensitivity analysis carried out when the transaction was last reviewed in July 2017; the declines were based on a sustainable net cash flow assumption of GBP 21.5 million (the Base Case) as the parameter used to determine the rating.

-- A decrease of 10% and 20% in the DBRS net cash flow (NCF), derived by looking at comparable properties, market rents and market occupancies, in addition to expenses ratios, capital expenditures and re-tenanting costs, would lead to the following ratings in the transaction, as noted below for each class, respectively:

Class A Notes Risk Sensitivity:
-- 10% decline in DBRS NCF, expected rating of Class A Notes of BB (low) (sf)
-- 20% decline in DBRS NCF, expected rating of Class A Notes of CCC (sf)

Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS’s outlooks and ratings are monitored.

This rating is Under Review with Negative Implications. Generally, the conditions that lead to the assignment of reviews are resolved within a 90-day period.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Rick Shi, Senior Financial Analyst
Rating Committee Chair: Christian Aufsatz, Managing Director
Initial Rating Date: 19 July 2013
DBRS Ratings Limited
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The rating methodologies used in the analysis of this transaction can be found at: http://www.dbrs.com/about/methodologies

-- European CMBS Rating and Surveillance Methodology
-- Legal Criteria for European Structured Finance Transactions
-- Unified Interest Rate Model for European Securitisations

A description of how DBRS analyses structured finance transactions and how the methodologies are collectively applied can be found at: http://www.dbrs.com/research/278375

For more information on this credit or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.